3.20 - Tools of Monetary Policy

The required reserve ratio and its effects

Central banks use the required reserve ratio (rr) as a monetary policy tool to influence the money supply by controlling how much commercial banks must hold in reserves.

The required reserve ratio

The required reserve ratio is the minimum percentage of customer deposits that commercial banks must keep as reserves, either in cash or as deposits with the central bank.

Effects of changing the required reserve ratio:

• Decreasing the ratio - Banks have more excess reserves to lend out, increasing money supply.
• Increasing the ratio - Banks must hold more reserves, reducing lending capacity and decreasing money supply.

This tool is rarely adjusted due to its abrupt effects on commercial banks' profitability.

The discount rate and money supply

The discount rate is another monetary policy instrument that central banks use to affect commercial banks' borrowing costs and, consequently, the overall money supply.

The discount rate

The discount rate, also known as the refinancing rate or base rate, is the interest rate charged by the central bank on short-term loans to commercial banks.

Effects of adjusting the discount rate:

• Lowering the rate - Banks can obtain additional reserves more cheaply, increasing lending and money supply.
• Raising the rate - Discourages banks from borrowing additional reserves, restricting money supply.

This tool is not frequently used as a regular tool but is employed during financial emergencies to ease pressure on banks with troubled loan portfolios.

Open market operations as a primary tool

Open market operations are the most commonly used monetary policy tool by central banks to adjust the money supply through transactions in government securities.

Open market operations

Open market operations involve the central bank buying or selling outstanding short-term government bonds (those maturing in less than a year) from or to commercial banks.

Effects of open market operations:

• Purchasing bonds - Bank reserves increase, allowing more lending and expanding money supply. For example, if a central bank purchases £400 million in bonds, the commercial banks hand over short-term government bonds they own and the central bank pays for them by crediting the reserves those banks hold with it.
• Selling bonds - Bank reserves decrease, forcing reduced lending and contracting money supply. A sale reverses both flows: the bonds pass to the commercial banks and the payment comes out of their reserves.

The diagram below shows a purchase. The bonds travel one way and the money the other (the dashed arrow is the money flow), and because the commercial banks hold more reserves afterwards they can lend more, so the money supply increases.

As the primary tool, open market operations allow for precise and gradual adjustments to liquidity in the banking system.

Quantitative easing for unconventional policy

Quantitative easing (QE) is an unconventional extension of open market operations, used when traditional tools are insufficient, particularly in low-interest-rate environments.

Quantitative easing

Quantitative easing involves large-scale purchases of longer-term financial assets by the central bank to inject liquidity into the economy. It was developed to address the zero lower bound (ZLB) problem, where interest rates approach zero.

Central banks, such as the Bank of England, the US Federal Reserve, the European Central Bank, and the Bank of Japan, implemented QE after the 2008-09 global financial crisis. It involves purchasing long-term (5-year or 10-year) government bonds, mortgage loans, and other financial assets. These purchases create large amounts of excess reserves, encouraging banks to lend more aggressively.

QE is typically reserved for severe economic downturns when standard monetary policy tools are ineffective.

Tools to increase or decrease money supply

Central banks employ a combination of tools to manage the money supply, aiming to achieve economic stability, control inflation, and support growth.

Whichever tool is used, the effect shows up in the money market. Because the central bank fixes the quantity of money, any tool that expands the money supply pushes the interest rate down, and any tool that contracts it pushes the interest rate up.

Tools for increasing money supply

These actions expand liquidity and encourage economic activity:

• Decrease the required reserve ratio.
• Decrease the discount rate.
• Buy short-term government bonds from commercial banks.
• Implement quantitative easing.

Tools for decreasing money supply

These measures restrict liquidity to curb inflation or cool an overheating economy:

• Increase the required reserve ratio.
• Increase the discount rate.
• Sell short-term government bonds to commercial banks.